New Tax Law Means
The Jobs and Growth Tax Relief Reconciliation Act
of 2003 dramatically alters the balance between competing types of
investments. The lower 15% tax rate for dividends should prompt
investors to reassess both their securities and the “pockets” in
which they hold their securities. Growth stocks still belong in
taxable accounts and interest-bearing investments in tax-deferred
accounts, but high-yielding equities now migrate from the
tax-favored “pocket” to the taxable.
The lower dividend tax should prompt investors to
examine possibilities for earning dividends in a more conservative
manner than outright ownership of common stocks. Fortunately,
there is a 20 year history of dividend capture strategies, which
until now were used by corporations aiming to get the dividends
received deduction, or DRD, without taking on too much risk. The
tax law applies the DRD rules to individuals capturing the 15% tax
on dividends, so individuals may now wish to replicate these
strategies. The rules regarding DRD eligibility seem simple,
although there are tricky exceptions. In essence, the rules
generally require that corporations hold their dividend-paying
shares for at least 46 days unhedged. For an individual
seeking to capture the 15% dividend tax, the unhedged holding
period would be 61 days. This requirement applies to every
dividend period. If investors hedge stocks during this period,
they generally will not be eligible for the reduced 15% dividend
tax for dividends on the hedged securities.
Update: Under the
American Jobs Creation Act of 2004, writing in-the-money
calls suspends the holding period required to capture
dividends or the DRD. See Tougher
Rules For Hedging Dividends.
During the 61-day holding period, the only
conventional derivative strategy that an investor may use to
protect the dividend-paying stock would be to sell a qualified
covered call option, or QCC. The rules defining QCCs were not
changed by the new law. These rules are complex, but a call
generally constitutes a QCC if it meets three basic conditions.
First, when the investor enters into the call, the call must have
more than 30 days remaining to expiration but not more than 33
months. Second, options on the underlying stock must be listed on
an options exchange. Third, the call must not be too deep
in-the-money, defined as having a strike price below a certain
minimum. This minimum strike price is usually one strike below
the stock’s previous day closing price, but, in addition, the
strike price must be at least 85% of the previous close, and a
more rigorous formula applies to calls with terms over twelve
The law generally allows investors to hedge their
portfolios with index options unless the portfolio and the index
“mimic” each other. A mimic of an index is defined as ownership
of 70% or more of the index.
Twenty-First also believes the new law should
heighten investor interest in a Lehman invention, the auction rate
preferred. This preferred’s interest rate is reset every 49 days
by auction. Because this system regularly adjusts the interest
rate to market conditions such as prevailing rate movements,
changes in credit quality, or even changes in tax rates, the
auction rate preferred is designed to always trade at par.
The new tax law allows a favorable arbitrage in
which an investor establishes both long and short positions in
different equities. The dividend income from the long positions
should be taxed at only 15%,
while short dividend payments should
be deductible against 35% income.*
|*The American Taxpayer
Relief Act of 2012 raised the rates on both long-
and short-term capital gains. The rates in this article do
not reflect these changes.
The new law should also change the dynamics of
stock loans. During the loan period, the borrower is generally
required to remit payments in lieu of any dividends distributed.
These substitute payments convert dividend income into ordinary
“other” income for the lender of shares. Beginning in 2004,
brokers will be required to report “in lieu of” dividend payments
as such, and these payments will be taxed as ordinary income at
the 35% rate. This extra tax would not apply to foreigners or to
tax-exempt investors, and the burden might be insignificant for
hedged investors and short-term traders. However, for many
individual investors, the tax consequences may be substantial, and
so these investors may become less willing to lend.
While the law changes the bottom line for many
investment strategies, it does not alter the way regulated futures
are taxed. Although a change was contemplated, under U.S.
Internal Revenue Code Section 1256, gains and losses on these
contracts are treated as 60% long-term and 40% short-term. Under
the new law’s tax rates, the net tax is lowered from 27.44% to
The tax law is clearly an historic piece of
legislation, and its ramifications are yet to be discovered.
However, one thing is clear: since dividends are now taxed as
favorably as long-term gains, substantial taxable investors should
be thinking more of equities.
|This article and
other articles are provided for
information purposes only. They are not intended to be
an offer to engage in any securities transactions or to
provide specific financial, legal or tax advice. Articles
may have been rendered partly inaccurate by events that have
occurred since publication. Investors should consult
their advisers before acting on any topics discussed herein|
and are not suitable for all
investors. Before engaging in an options
transaction, investors must review the booklet "Characteristics
and Risks of Standardized Options".